Question

Firms A & B have no debt. Both have invested capital of $4,000,000 and 200,000 shares
outstanding. Both firms have an ROIC of 15% and a WACC of 15%. Firm A pays out 100% of
earnings as dividends and Firm B pays out 30% of its earnings as dividends.

a. What will be the share price of each firm at the end of two years?

b. Will shareholders of Firms A & B earn the same or different rates of return after selling
their shares at end of year two assuming both firms continue to operate as they have and
there are no changes in expectations.

Answer 1

Sol. (a) (i) Share price of Firm A = (Invested Capital + Earnings for 2 years - Dividend for 2 years) / No. of shares outstanding

= (4,000,000 + 1,200,000 - 1,200,000 ) / 200,000 (Earning for 2 years = 4,000,000 * 0.15 * 2 = 1,200,000)

= $ 20 per share (Dividend for 2 years = Earning * 100% = 1200,000)

(ii) Share price of Firm B = (Invested Capital + Earnings for 2 years - Dividend for 2 years) / No. of shares outstanding

= (4,000,000 + 1,200,000 - 360,000 ) / 200,000 (Dividend = 1200,000 * 0.30 = 360,000)

= $ 24.20 per share

(b) The earnings of shareholders of firm B will be more than that of firm A, :

(i) As the price of shares of firm B are higher as they haven't distributed much dividend as compared to firm A.

(ii) And there are less chances that shareholders of Firm B have got another opportunity to invest in other co. that provides such a high rate of return.

Thus it can be said that out of these arrangements shareholders of Firm B will get more rate of return when seen collectively for 2 years.